Netflix takes a beating following run-up

DVD rental firm loses premium generated by Amazon buyout rumors

By

DanGallagher

SAN FRANCISCO (MarketWatch) -- Netflix Inc. has earned kudos for its ability to deliver top-flight service to millions of movie watchers, but the company's investors have undergone their own drama over the past few days.

Rumors of a buyout deal with online retail giant Amazon.com pumped up Netflix's shares last week. The stock nearly reached the $26 mark last Wednesday -- its highest level in six months and up more than 20% in two days.

This week, the shares have given up that premium. Shares of Los Gatos, Calif.-based Netflix
NFLX, -1.12%
dropped under the $20 mark Wednesday, hitting their lowest price since August of last year.

Over the past three days, the stock has lost more than 18% as analysts from J.P. Morgan and Citigroup have downgraded the shares on concern about fresh competition from Blockbuster Inc.
BBI, +4.41%
the company's main rival, which cut prices on its own online DVD rental service this week to levels below the prices for comparable offers from Netflix.

"We expect that Netflix will eventually have to match the price cuts or lose significant share to Blockbuster," wrote Tony Wible of Citigroup, who cut his rating on the stock to sell on Tuesday. "We believe this [Amazon buyout] scenario is a possibility, but not a probability due to certain fundamental hurdles such as competitive uncertainties with Blockbuster and digital downloads."

Rumors of Seattle-based Amazon
AMZN, +1.24%
buying Netflix have circulated on Wall Street several times in the past couple of years. But the speculation has taken on renewed vigor given Amazon's latest run, in which the stock has surged more than 65% to a seven-year high since its latest earnings report in April.

But many analysts dismissed the rumors. For one thing, they point out that buying Netflix could endanger Amazon's ability to sell goods without collecting sales tax. See full story.

Blockbuster undercutting on price

Now, Amazon or any potential Netflix buyer will have to contend with the Total Access service launched by Blockbuster. For about $18 a month, Blockbuster subscribers can have three DVDs out at a time and either mail them back or take them to a Blockbuster store for an exchange.

The Dallas-based company also now offers an online-only service at $17 per month -- about $1 below the comparable service from Netflix.

"That means, we believe, that Netflix at best will split growth in online video rental subscribers with Blockbuster, rather than have a dominant share of subscriber growth -- a meaningfully more conservative long-term outlook than we believe is priced into Netflix's shares," wrote Barton Crockett of J.P. Morgan, who downgraded Netflix to an underweight rating on Monday.

Crockett added that he does not believe Blockbuster will give in soon on the price cuts, which he believes is losing money for the company. Rather, he thinks Blockbuster will be able to make up the difference through in-store sales and other programs.

Netflix value 'difficult to quantify'

Investors may still be hoping for a buyout deal, though Netflix management has given no indication to date that they are seeking one.

Rather, the company is seeking to further differentiate itself by jumping into the video-on-demand market. Netflix already offers some movies on its Web site that subscribers can watch without having to download.

At an industry conference last week, Netflix CEO Reed Hastings outlined three tiers of the video-on-demand market. The ad-supported level has been popularized by YouTube while the purchase model has been led by Apple's iTunes service. He said Netflix intends to lead the subscription-based, or rental, model.

In an analysis of the company last week, Gordon Hodge of Thomas Weisel said Netflix offers a lot of value to a potential acquirer, but many of the company's most valuable assets are "difficult to quantify."

These include the company's top-rated service and the reams of data it gathers on its customers' movie preferences, which helps it recommend new shows to subscribers.

"For competitive subscription movie services such as HBO, Showtime and Starz who do not know who their customers are due to their wholesale relationships with cable and satellite distributors, we believe Netflix's direct customer relationships and databank of personalized movie preferences could have immense strategic value," Hodge wrote in his report.

He added, however, that Amazon has a large advantage over other potential suitors.

"What the pay TV networks lack, however, that Amazon has in abundance recently is a high-multiple stock to use as currency should it wish," he wrote.

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